New players to the investing game often ask what convertible bonds are, and whether they are bonds or stocks. Essentially, they are corporate bonds that can be converted by the holder into the common stock of the issuing company. In this article, we'll cover the basics of these chameleon-like securities as well as their upsides and downsides.

What Is a Convertible Bond?
As the name implies, convertible bonds, or converts, give the holder the option to exchange the bond for a predetermined number of shares in the issuing company. When first issued, they act just like regular corporate bonds, albeit with a slightly lower interest rate. Because convertibles can be changed into stock and thus benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles. If the stock performs poorly there is no conversion and an investor is stuck with the bond's sub-par return (below what a non-convertible corporate bond would get). As always, there is a tradeoff between risk and return. (For more insight, read Get Acquainted With The Bond Price-Yield Duo.)

Conversion Ratio
The conversion ratio (also called the conversion premium) determines how many shares can be converted from each bond. This can be expressed as a ratio or as the conversion price, and is specified in the indenture along with other provisions.

A conversion ratio of 45:1 means one bond (with a $1,000 par value) can be exchanged for 45 shares of stock. Or it could be specified at a 50% premium, meaning that if the investor chooses to convert the shares, he or she will have to pay the price of the common stock at the time of issuance plus 50%. Basically, these are the same thing said two different ways.

This chart shows the performance of a convertible bond as the stock price rises. Notice that the price of the bond begins to rise as the stock price approaches the conversion price. At this point your convertible performs similarly to a stock option. As the stock price moves up or becomes extremely volatile, so does your bond.


It is important to remember that convertible bonds closely follow the underlying's price. The exception occurs when the share price goes down substantially. In this case, at the time of the bond's maturity, bond holders would receive no less than the par value.

Forced Conversion
One downside of convertible bonds is that the issuing company has the right to call the bonds. In other words, the company has the right to forcibly convert them. Forced conversion usually occurs when the price of the stock is higher than the amount it would be if the bond were redeemed, or this may occur at the bond's call date. This attribute caps the capital appreciation potential of a convertible bond. The sky is not the limit with converts as it is with common stock. (To learn more about callable bonds, read Bond Call Features: Don't Get Caught Off Guard.)

The Numbers

As we mentioned earlier, convertible bonds are rather complex securities for a few reasons. First, they have the characteristics of both bonds and stocks, confusing investors right off the bat. Then you have to weigh in the factors affecting the price of these securities; these factors are a mixture of what is happening in the interest-rate climate (which affects bond pricing) and the market for the underlying stock (which affects the price of the stock).

Then there's the fact that these bonds can be called by the issuer at a certain price that insulates the issuer from any dramatic spike in share price. All of these factors are important when pricing convertibles.

Suppose that TSJ Sports issues $10 million in three-year convertible bonds with a 5% yield and a 25% premium. This means that TSJ will have to pay $500,000 in interest annually, or a total $1.5 million over the life of the converts.
If TSJ\'s stock was trading at $40 at the time of the convertible bonds issue, investors would have the option of converting those bonds for shares at a price of $50 ($40 x 1.25 = $50). Therefore if the stock was trading at say $55 by the bond\'s expiration date, that $5 difference per share is profit for the investor. However there is usually a cap on the amount the stock can appreciate through the issuer\'s callable provision.
For instance, TSJ executives won\'t allow the share price to surge to $100 without calling their bonds - and capping investors\' profits. Alternatively, if the stock price tanks to $25 the convert holders would still be paid the face value of the $1,000 bond at maturity. This means that while convertible bonds limit risk if the stock price plummets, they also limit exposure to upside price movement if the common stock soars.

Getting caught up in all the details and intricacies of convertible bonds can make them appear more complex then they really are. At their most basic, convertibles provide a sort of security blanket for investors wishing to participate in the growth of a particular company they're unsure of. By investing in converts you are limiting your downside risk at the expense of limiting your upside potential.

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: SPDR Barclays Convertible Secs

    Read an in-depth analysis of the SPDR Barclays Capital Convertible Bond ETF, which tracks an index of high-growth potential convertible bonds.
  2. Mutual Funds & ETFs

    Top 3 Inflation Protected Bond Mutual Funds

    Learn about the characteristics and suitability of the top inflation-protected bond mutual funds, and how investors can use these funds to their advantage.
  3. Stock Analysis

    The Biggest Risks of Investing in Apple Stock

    Read about the biggest risks facing Apple, Inc., and why AAPL investors should always be prepared for the day when the tech giant starts to struggle.
  4. Stock Analysis

    Top 5 Companies Owned by Ford

    Discover some of Ford Motor Company's most important subsidiaries and joint ventures, and learn more about what they do to further Ford's business interests.
  5. Stock Analysis

    Top 5 Companies Owned by Exxon Mobil

    Learn more about some of the biggest subsidiaries and joint-venture companies in the Exxon Mobil family, including both domestic and international businesses.
  6. Investing

    Binary Options For Capital-Protected Investments

    Binary options may sound complex, but they can be used to create capital-protected investments. Here's how.
  7. Bonds & Fixed Income

    An Assessment of High Yield Corporate Bond Credit Spreads

    A credit risk literature review.
  8. Investing Basics

    How to Think About Seasonality Trends

    Investors benefit when company research incorporates seasonality trends that predict relative strength and weakness throughout the calendar year.
  9. Bonds & Fixed Income

    A Guide to High Yield Corporate Bonds

    The universe of corporate high yield bonds encompasses multiple different types and structures.
  10. Bonds & Fixed Income

    A Brief History of the U.S. High Yield Bond Market

    The U.S. high-yield corporate bond market has existed for decades: it's known for its rapid growth periods as well as its risks.
  1. How safe are variable annuities?

    Life insurance companies are facing a challenging environment. Those that sell variable annuities have been able to mitigate ... Read Full Answer >>
  2. Why are mutual funds subject to market risk?

    Like all securities, mutual funds are subject to market, or systematic, risk. This is because there is no way to predict ... Read Full Answer >>
  3. Can mutual funds only hold stocks?

    There are some types of mutual funds, called stock funds or equity funds, which hold only stocks. However, there are a number ... Read Full Answer >>
  4. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  5. Do mutual funds pay interest?

    Some mutual funds pay interest, though it depends on the types of assets held in the funds' portfolios. Specifically, bond ... Read Full Answer >>
  6. Why have mutual funds become so popular?

    Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Ex Works (EXW)

    An international trade term requiring the seller to make goods ready for pickup at his or her own place of business. All ...
  2. Letter of Intent - LOI

    A document outlining the terms of an agreement before it is finalized. LOIs are usually not legally binding in their entirety. ...
  3. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  4. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  5. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  6. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!